What is the yield curve? Wall Street recession alarm is sounding.

What Wall Street has talked about most about the recession indicator is sounding the biggest alarm in two decades, intensifying fears among investors that the US economy is heading for a slowdown.

This indicator is called the yield curve, and it’s a way of showing how interest rates on various US government bonds compare.And the In particular, three-month Treasury bills and two- and 10-year Treasury bonds.

Typically, bond investors expect to get paid more for holding their money for the long term, so the interest rates on short-term bonds are lower than those on long-term bonds. On the chart, the different yields of the bonds create an upward sloping line – the curve.

But every now and then, short-term interest rates rise above long-term rates. This negative relationship twists the curve into a so-called reversal, and indicates that the normal in the world’s largest government bond market has been reversed.

They have both overturned American recession Over the past half century, it is therefore seen as a harbinger of economic doom. This is happening now.

The yield curve has a predictive power that other markets do not have.

On Wednesday, the yield on the two-year Treasury was 3.23 percent, higher than the 3.03 percent yield on the 10-year Treasury. A year ago, for comparison, two-year returns were more than one percentage point lower than 10-year returns.

The Fed’s mantra on inflation at the time was that inflation would be temporary, meaning the central bank did not see the need to raise interest rates quickly. As a result, short-term Treasury yields remained low.

But over the past nine months, the Fed has become increasingly concerned that inflation won’t go away on its own, and has begun addressing price hikes quickly with Raise interest rates quickly. By next week, when the Fed is expected to raise interest rates again, its policy rate will have jumped about 2.5 percentage points from near zero in March, and that has driven up yields on short-term Treasuries like the two-year note.

On the other hand, investors are increasingly afraid that the central bank will go too far, slowing the economy to the point of causing a sharp downturn. This concern is reflected in long-term Treasury yields such as 10 years, which tell us more about investors’ expectations for growth.

That concern is also mirrored in other markets: US stocks are down nearly 17 percent so far this year, as investors reassess companies’ ability to withstand a slowdown in the economy. The price of copper, the world leader due to its use in a range of consumer and industrial products, fell by more than 25 percent; And the U.S. dollarA haven in periods of anxiety, it is at its strongest in two decades.

What sets the yield curve apart is its predictive power, and the recession signal it sends is now stronger than it has been since the late 2000s, when the tech stock bubble began to burst and a recession was just a few months away.

That recession occurred in March 2001 and lasted about eight months. By the time it started, the yield curve was already back to normal as policy makers started cutting interest rates to try to bring the economy back to health.

The yield curve also predicted The global financial crisis that began in December 2007inverted initially in late 2005 and continued that way until mid-2007.

This track record is why investors across financial markets have now noticed that the yield curve has inverted again.

“The yield curve is not the gospel, but I think it’s at your own risk to ignore it,” said Greg Peters, chief investment officer at PGIM Fixed Income Asset Management.

But which part of the yield curve is important?

On Wall Street, the most popular part of the yield curve is the relationship between two-year and 10-year bond yields, but some economists prefer to focus on the relationship between the yield on three-month and 10-year bonds instead.

This group includes one of the pioneers in research into the predictive power of the yield curve.

Campbell Harvey, now an economics professor at Duke University, remembers being asked to develop a model that could forecast US growth while he was a summer intern at the now-defunct Canadian miner Falconbridge in 1982.

the master. Harvey shifted the yield curve but the US had already been in recession for about a year and was quickly laid off by the economic climate.

It wasn’t until the mid-1980s, when he earned his Ph.D. Candidate at the University of Chicago completed search it It turns out that the reversal of the three-month and 10-year returns preceded the recessions that began in 1969, 1973, 1980 and 1981.

the master. Harvey said he prefers to look at the three-month yields because they are close to current conditions, while others indicated that they directly accommodate investors’ expectations of immediate changes in Fed policy.

For most market watchers, all the different ways of measuring the yield curve broadly point in the same direction, indicating slowing economic growth. It’s “different flavors, but it’s all still sundaes,” said Bill O’Donnell, interest rate strategist at Citibank.

Three-month returns are still lower than 10-year returns. So by this metric, the yield curve hasn’t inverted, but the gap between them is rapidly shrinking as concerns about a slowdown mount. By Wednesday, the spread between returnees had fallen from more than two percentage points in May to about 0.5 percentage point, the lowest level since the pandemic-induced downturn in 2020.

The yield curve cannot tell us everything.

Some analysts and investors argue that interest in the yield curve as a common recession signal is overstated.

One common criticism is that the yield curve doesn’t tell us much about when a recession will start, but it is likely that there will be a recession. The average time it takes a recession after two-year bond yields to rise above 10-year yields is 19 months, according to data from Deutsche Bank. But the term extends from six months to four years.

The economy and financial markets have also evolved since the 2008 financial crisis, when the model was last in vogue. The Federal Reserve’s balance sheet ballooned as it repeatedly bought Treasuries and mortgages to help support financial markets, and some analysts argue that these purchases could distort the yield curve.

These are the two points that Mr. said. Harvey accepts. The yield curve is a simple way to predict the growth trajectory of the United States and the probability of a recession. It has been proven reliable but it is not perfect.

It is suggested to use in conjunction with surveys Economic Outlook among Chief Financial Officerswho typically hold back on corporate spending when they become more concerned about the economy.

He also cited corporate borrowing costs as an indicator of the risks investors perceived in private corporate lending. These costs tend to rise as the economy slows. Both metrics are telling the same story right now: the risk is rising, and expectations are growing for a slowdown.

“If I go back to the summer internship, will I look at the yield curve? No,” Mr. Harvey said.

But that also does not mean that it is no longer a useful indicator.

“It is more than useful. It is very valuable.” Harvey said. “Managers of any company have to take the yield curve as a negative sign and engage in risk management. And for the people, too. Now is not the time to get the most out of your credit card on an expensive vacation.”